Mythbusting: Stocks are riskier than Bonds (Episode 001)

In this episode of The DIY Investing Podcast, I discuss the common myth that stocks are riskier than bonds. Join me as I bust this myth, by discussing the capital asset pricing model, beta, volatility, and redefine risk for an investor.

See below for an approximate transcript of the podcast:

Hello and welcome to Episode 1 of the DIY Investing Podcast. My name is Trey Henninger and I’m your host. As the inaugural episode of the DIY Investing Podcast, I must begin with a very provocative statement:

“Everything you think you know about investing is based upon a lie.”

Perhaps, if you’re a long-time student of Value Investing, this won’t be true, as you’ve already discovered the numerous myths that abound as truth in the mainstream media about investing. However, for most of you, if you read CNBC, listen to other financial podcasts, or read financial blogs, you likely have accepted a bunch of information to be true, which simply isn’t based in reality.

Today’s show will focus on busting the myth on one of the most pervasive maxims of the mainstream financial media:That Stocks are riskier than Bonds. I have no doubt that unless this is the first time you’ve ever heard anything about investing, that you’ve heard this statement. What I have to tell you, is that not only is that false. Stocks are NOT riskier than Bonds, the opposite is in fact true. Bonds are in most situations, riskier than stocks.

We’re going to dive deep into this idea of the relative risk between stocks and bonds, but before we do, I want to highlight some similar investing assumptions and statements which you’ve probably been told:

Stocks are Risky. (False – Sometimes)

Bonds are Safe. (False – Sometimes)

Stocks are more volatile than bonds, therefore they have more risk. (FALSE). Stocks do tend to be more volatile, but that doesn’t mean they are riskier.

In order to have higher returns, you have to take more risk. (FALSE)

One of the most important decisions you make is deciding upon your asset allocation between stocks and bonds. (FALSE)

This is because to increase your returns you need to increase your exposure to stocks, but to become more conservative you need to increase your exposure to bonds. (FALSE)

So, now that I’ve broken the ice, It’s time to dive in and learn how these false ideas reached the point where they are now seen as near universal truths. The outline of the rest of the show will be like this:

Discussion of the history of the idea that Stocks are riskier than Bonds. This section will mainly be discussing the Capital Asset Pricing Model, and why it’s wrong.

Brainstorming a definition of risk which you can use as the foundation for your investing.

Summing it all back up, so that you can begin to make better investing decisions.

Capital Asset Pricing Model and Beta/Volatility

First, why is it that Stocks are defined as risky. To understand this, we need to understand the mainstream definition of investment risk:

“Investment risk, then, is the chance that expected security returns will not materialize and, in particular, that the securities you hold will fall in price. … Thus, financial risk has generally been defined as the variance or standard deviation of returns.”

Now, definitions will vary slightly, but the plain english version of this definition is that the more volatile an asset is, that is the larger the changes in stock price or bond price, the riskier the asset.

This immediately presents a problem. The standard deviation of a security which could be stocks or bonds, increases when price changes occur either in the negative OR the positive direction. The problem becomes evident when you talk about the realistic effects of this.

Example 1:

Let’s say you have two companies. Amazon and Ford. You buy shares in Both companies. Both companies have a stock price of $100. In one years time, Amazon’s stock price has doubled and is now $200 per share, while Ford’s stock price has declined by 5% to $95 per share.

Under this scenario, the standard deviation, or Stock Beta, or Volatility of Amazon is much higher than the volatility of Ford. Therefore, the Capital Asset Pricing Model says that Amazon was a riskier stock to own than Ford. This is in spite of the fact that Amazon gave you a 100% gain, while Ford lost 5% of your money.

Lesson:Only negative changes in price should ever be considered when determining the risk.If the stock price going up, and me making money equals risk, then I would want risk. However, all that highlights is that the definition of risk is flawed.

Second example:

In this scenario, imagine we have only one company. In this case, Apple Computer. Apple is currently the most profitable and largest company in the US Stock Market. I’m going to use round numbers for this example, so understand that these numbers won’t necessarily match exactly with the current market.

At the time I’m recording this episode, Apple Stock is trading for approximately $140 per share. Yahoo Finance shows that Apple currently has a beta of 1.44 or 44% higher volatility than the stock market. Under the Capital Asset Pricing Model, the volatility of the stock market is assumed to equal a beta of 1.

I’m not going to go into the details of how to calculate beta, because that skill is absolutely useless to you as a value investor. However, one of the key aspects to understand is how the calculation of beta works. One of the key aspects is, that a large drop in the stock price of a stock will increase it’s “Beta” because it’s “volatility” has supposedly increased. Therefore, by the definition of the Capital Asset Pricing Model, if the stock price of Apple fell 50% from $140 per share to $70 per share, it would become a “riskier” investment.

Logically, this makes absolutely no sense. As a value investor, If you are a net buyer of stocks, you want to buy shares of stock at the lowest price you can, because you’re trying to buy at a discount to intrinsic value.A quick definition of intrinsic value is the total value of all future cash flows of a business. This value does NOT change in relation to stock price. It changes purely in relation to fundamentals.So, regardless of what the intrinsic value of Apple Stock is, Apple Stock will be a better buy at $70 per share than at $140 per share, all else equal. That’s a key statement, because it assumes that the change in price of the stock, was not due to a change in the fundamentals of the underlying business. Which is true for most short-term stock price changes.

If for example, the Intrinsic Value of Apple today was $100 per share. (I’m not saying it is, but let’s assume so for this example) It’s currently trading at $140, so it would be 40% overvalued. If instead, it dropped by 50% tomorrow, to $70 per share. $70 is 30% below $100 so it’s now 30% undervalued. Apple just went from being a bad buy to a good buy.

Lesson: Buying a stock at a lower price means it is Less risky, not more risky, as the Capital Asset Pricing Model Suggests.

To further understand the capital asset pricing model, and why it’s flawed, let’s look at the assumptions behind the model:

CAPM assumes:

Investing your money based on the assumptions of the capital asset pricing model is quite risky. No different from gambling your money on the roll of dice.

No transaction costs (no commission, no bid-ask spread)

Investors can take any position (long or short) in any stock in any size without affecting the market price

No taxes (so investors are indifferent between dividends and capital gains)

Investors are risk averse

Investors share a common time horizon

Investors view stocks only in mean-variance space (so they all use Markowitz’s optimization model)

Investors control risk through diversification

All assets, including human capital, can be bought and sold freely in the market

Investors can lend and borrow at the risk free rate

Finale lesson for this section: Understanding the relationship between risk and return.

The standard maxim I stated at the beginning was that in order to increase your return you have to take on more risk. Let’s think about this logically, does that make any sense at all? If I gave you two fictional investments. You can either invest in Widget Corporation or Services Corporation. Both companies are asking for a $1000 investment. However, Widget Corporation has a 1% chance of going bankrupt each year for the next 5 years, while Services Corporation has a 10% chance of going bankrupt each year for the next 5 years.

9 times out of ten, which investment do you think is riskier, and is that the same company which will likely leave you with the best return on your investment? It’s quite obvious that the Services Corporation is the riskier investment. An investor in the Widget Corporation has a much better chance of ending up with a positive investment, let alone allowing you to avoid owning a company that could go bankrupt.

Notice, how none of this discussion of risk, had anything to do with the volatility of the share price.

That leads us into our next section:

Brainstorming a definition of risk:

Definition of Risk necessarily requires derivation from our definition of an investment. Which is itself based upon Ben Graham’s definition of an investment operation.

Benjamin Graham, the father of Value investing, with his Co-Author David Dodd, attempted a gave the following definiton of an investment in their 1934 bookSecurity Analysis.“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

So if an investment operation requires safety of principal and achieving of a satisfactory return, then our definition of investment risk needs to take this into account.

Investment Risk is the quantifiable chance that one of two scenarios occur:

1. Loss of principal

2. Failure to achieve a suitable rate of return on investment

These two scenarios are interrelated. If Loss of Principal occurs, then by definition, you will fail to achieve a suitable rate of return on your investment. By this understanding, preventing a loss of principal is a necessary but insufficient condition for achieving a suitable rate of return.

Therefore, we can break risk up into two categories:

Loss of Principal Risk

Risk of earning a less than adequate rate of return

Loss of Principal risk factors:

Reduction in quality of earnings of the company

Material reduction in the long-term earnings capability of the company

Liquidity event leading to bankruptcy of company and the equity in the company becoming worthless

Because not losing your principal is a pre-requisite for earning an adequate return, all of the risk factors related to Loss of Principal are true as well for earning an adequate return. However, there are also additional factors.

This can be mitigated by making the holding period as long as possible. (Preferably forever, or held until death)

Defining what a proper satisfactory rate of return is:

In the words of Sir John Templeton“For all long-term investors, there is only one objective ? maximum total real returns after taxes”

What do we learn from this: Your returns need to be taken into account after-taxes, but they also need to be “real returns.” Real returns are returns AFTER inflation.

If you invest $30,000 today, or about what it costs to buy a brand new car, and you invest it for 15 years, and it becomes $100,000 that can sound great. You more than tripled your money. But if a brand new car now costs $200,000, so you can only buy half of a new car due to rampant inflation, you’ve now lost money.

This is where bonds really struggle, they might show positive returns, but recently they have struggled to even match or beat inflation. That is by no means safe.

So, how do this understanding of risk allow us to evaluate whether stocks or bonds are riskier. One of the key aspects to understand is that volatility alone is a BAD definition of risk. Stocks tend to be more volatile than bonds, that’s true. However, stocks do a great job at beating inflation over long periods of time. Bonds, on the other hand have a bad history. They have much lower rate of return over long periods of time.

The reason for this is fairly simple, a corporate bond and a corporate stock are both investments in a company. However, only stocks provide the upside for growth in earnings. And companies work each and every day to make more money than the previous year. This allows your dividends to increase each year. When you own a major corporation, you’ve hired tens of thousands of employees to spend 40 hours a week trying to find ways to make your more money. Meanwhile, when you buy a bond, your rate of payment is set in stone. It’s not going to budge, regardless of how much you’d like it to increase.

This is the core reasons that stocks tend to outperform bonds over the long term. By outperform, I mean that stocks have a larger after-tax, after-inflation return. And based upon our original definition, that’s the purpose of an investment. It’s also the exact opposite of risk. Because stocks in the aggregate have the ability to increase their earnings and dividends over time, they are usually a better investment and they pose less risk.

The final ingredient of risk is price. Price is all important to a value investor. There is a price at which bonds are a better investment than stocks, and there is a price where stocks are a better investment than bonds. A high price equals risk, because the higher the price, the greater the chance that you will “lose principal.” As we said earlier, your first goal is to “protect your principal.” Therefore, it’s not as simple to say that stocks are riskier than bonds or bonds are riskier than stocks. While stocks might in general, be better long term investments, this only true when prices are rational and low. My current guess is that both bonds and stocks are extremely overpriced and we’re in the midst of another asset bubble.

Summary:

An investment: Promises safety of principal and a satisfactory return

Investment Risk is the quantifiable chance that one of two scenarios occur:

1. Loss of principal

2. Failure to achieve a suitable rate of return on investment

Therefore, determining the risk of an investment is not something which can be easily defined by a single mathematical number like stock volatility or beta.

Determining the risk inherent in an investment requires in-depth fundamental analysis of the specific earnings capability of a business. The mainstream media HATES this definition precisely because it means that investing is not as easy as they make it sound.

Proper value investing is going to require some work. It’s going to require some understanding of how businesses operate and how companies make profit.

Understanding that it’s a bit more complicated than simply choosing an asset allocation between stocks and bonds is only the first step. Stocks and bonds must be bought with the intention of protecting principal and receiving an adequate return on investment. In general, it’s easier to achieve this goal with stocks, because the cash payments you receive can grow. Bonds, struggle to beat inflation in our current day in age. This can always change, however.

That’s why it’s important as a value investor to understand what your target rate of return is, and to be able to evaluate the price you need to pay in order to achieve that return.

Final takeaway: Take what you hear in the mainstream investing media with a grain of salt. The mainstream media likes to promote stock traders, and not value investing. Stocks are most definitely not riskier than bonds, and the Capital Asset Pricing Model this idea is based on, is nonsense.

Thank you for listening to today’s podcast. If you liked this content and found it valuable, please subscribe and consider sharing with your friends so they can learn from it as well.

If you’d like to find the show notes, you can find them atdiyinvesting.org/epsiode1.

About Trey Henninger

Trey is a private investment portfolio manager for his own personal funds. He began investing in 2011 and has over 7 years of experience managing an investment portfolio as well as performing fundamental stock and business analysis. Trey has been writing about his investing research, investing theory, and personal finance since 2015. He used thousands of hours of reading and learning to teach himself to invest and hopes to help other like-minded investors become DIY investors as well.

Trey graduated from the University of Texas with a Bachelor of Science degree in Chemical Engineering with a concentration in Engineering Economics and Business Leadership. He leverages this background in engineering economics to better identify and understand capital intensive and capital-light businesses. He has been quoted on Nerd Wallet, InvestorPlace, GoBankingRates and other online publications.

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